No cause for panic in emerging markets

EMERGING MARKET BONDS, nearly all observers agree, have risen about as far as they can go. With spreads at these levels, the chances of significant capital appreciation are minimal; the best that investors can hope for is that there won't be much widening for the rest of the year.

In such an environment, where analysts on both the buy side and the sell side foresee a total return for emerging-market debt in the region of zero, investors are inevitably going to look to other methods of beefing up their yields. Foremost among those is leverage.

There are no hard figures on the amount of leverage in the asset class; such things are impossible to measure. But total volumes have been growing steadily and, anecdotally speaking, investors and analysts say that there's nearly as much leverage now as there was in 1997-98, just before Russia and Long Term Capital Management dragged the market down precipitously.

Players today – foremost among them the dozens of small emerging-market hedge funds that have been set up in the past couple of years – aren't as large as LTCM was, and don't therefore constitute the same kind of systemic risk. But there are many more of them, and most of them are playing the global carry trade in one form or another.

It makes a certain amount of sense. US short-term rates are being kept artificially low by the Federal Reserve so it is possible to borrow for the short term at about 1% and invest the proceeds in slightly longer duration emerging-market debt yielding, say, 5%. Nothing too risky, but since the capital requirements are low, the total returns can be reasonably good.

Obviously, the main risk is that bond prices will fall, maybe because of worries about an interest rate increase from the Fed. In recent months, we've seen small changes in Fed language translate to double-digit percentage point plunges in emerging-market bond prices: a clear indication of stop-losses and/or margin calls causing an overshooting of prices.

Even so, spread volatility has remained at all-time lows, and the carry trade has performed well overall. The previous low in spread volatility was in 1997, when daily volatility reached 125 basis points on an annualized basis. Today, that number is closer to 100bp.

Part of the reason for this is that event risk in emerging markets is much less of a problem now than it was in 1997. Back then, contagion was a huge issue not only because of the amount of leverage in the market but also because of the domino effect of fixed currency regimes collapsing and forcing devaluations in neighbouring countries. Now that nearly all emerging-market issuers have free-floating currencies, that is much less of an issue.

Meanwhile, although net capital flows into emerging markets have been large of late, they are still a fraction of the numbers seen in 1996 and 1997. That's a good thing. Less 'hot money' means less chance of panic.

And, slowly, the much more desirable foreign direct investment, which was conspicuous by its absence in 2003 – is picking up as well. Most recently, Belgian brewer Interbrew bought Brazil's AmBev for $11.5 billion in a complex transaction that marked the welcome return of mega-deals to Latin America.

So although increased leverage in the asset class is a cause for concern, it is definitely not a reason to start exiting the market. Comparisons with 1997 are illuminating; virtually everything is less risky now than it was then. The asset class as a whole is less complex, with almost 85% in the form of plain-vanilla Eurobonds rather than the much more opaque Brady bonds that dominated the market seven years ago. And risk management tools are more sophisticated: the credit derivatives market, at $480 billion, is an order of magnitude larger than it was then.

Meanwhile, such countries as Mexico have developed mature domestic markets, largely obviating the need for foreign debt issuance in the first place, and slashing the size of potential currency mismatches between assets and income on the one side and liabilities on the other.

Most crucially, even if and when the Fed does raise rates and bond prices fall, we are very unlikely to see a mass desertion of the asset class and a flight to quality like that in 1998.

"There's a big difference between price volatility and default risk perception," notes Marc Balston, head of emerging markets quantitative research at Deutsche Bank in London. "In 1998, there was a dramatic rise in perception of credit risk," he adds.

In other words, investors didn't sell in 1998 just because their leveraged positions started crumbling from underneath them: they also sold because they were afraid of a series of emerging-market defaults. Today, when emerging markets are running current-account surpluses rather than deficits, and when external financing needs are a fraction of their former levels, few countries look to be at serious risk of defaulting on their external debt.

If an investor has a medium-term to long-term time horizon, then, volatility in asset prices should not be too much of an issue. Real-money investors can ride out market volatility if they are committed to the asset class, and increasingly that seems to be the case.

The substantial inflows into the emerging-market asset class "have been much more longer-term strategic money rather than tactical allocations", says Balston, who thinks that for a core fixed-income portfolio a neutral allocation to emerging-market debt would probably be in the 3% to 4% range. That's not necessarily because emerging-market debt accounts for that much of the total fixed-income universe, so much as because emerging-market debt doesn't always move in line with other fixed-income instruments, so it provides some diversification.

If oil prices rise, for instance, most bond spreads have a tendency to widen. Some emerging markets, though, such as Russia and Mexico, benefit from high crude prices.

Increasingly, this is an argument that is being accepted by the world's largest money managers, which are putting more of their investments into emerging-market funds. Assets under management in dedicated funds rose some 30% in 2003, to somewhere between $15 billion and $20 billion, while emerging-market assets held in global funds could well be three or four times larger still. While some of that money could panic in the next downturn, most of it is going to stay.